A 1031 exchange allows you to defer capital gains taxes when selling an investment property by reinvesting the proceeds into another like-kind property. This process is governed by strict IRS rules and specific state regulations.
Steps to Complete a 1031 Exchange
1. Identify Your Properties
- Relinquished Property: The property you are selling.
- Replacement Property: The property you intend to buy.
2. Engage a Qualified Intermediary
You must use a Qualified Intermediary (QI) to facilitate the exchange. The QI holds the proceeds from the sale of your relinquished property and helps ensure compliance with IRS regulations.
3. Follow IRS Timelines
- 45-Day Rule: You have 45 days from the sale of your relinquished property to identify potential replacement properties.
- 180-Day Rule: You must complete the purchase of the replacement property within 180 days of the sale.
Hawaii-Specific Considerations
Withholding Tax Exemption
In Hawaii, there is a 7.25% real estate tax withholding for non-residents. However, if you are performing a 1031 exchange, you can claim an exemption by completing Form N-289, which allows you to avoid this withholding.
Like-Kind Property Definition
In Hawaii, like-kind properties can include various types of real estate, such as:
|
Property Type |
Examples |
|
Residential |
Multifamily apartments, condos |
|
Commercial |
Retail centers, office buildings |
|
Land |
Vacant land, agricultural land |
A 1031 Exchange in Hawaii is a type of tax-deferred exchange that allows you to defer the capital gains taxes associated with the sale of a property located in Hawaii. This type of exchange allows for the deferment of capital gains taxes on the exchange of real estate held for investment or business purposes.
1031 Exchange Rules in Hawaii
In order to be eligible for a 1031 Exchange in Hawaii, there are a few key points that must be met. The first is that the exchange must be an “Exchange of Like-Kind.” This means that the exchanged property must be of the same type and quality. Additionally, both properties must be held for investment or business purposes.
Timing the 1031 Exchange
The second key point to a successful 1031 Exchange in Hawaii is the timing of the exchange. The exchange must be completed within 180 days of the sale of the original property that is being exchanged.
The 180-day real estate timeline begins on the closing date of the sale of the relinquished property and ends on the closing date of the acquisition of the replacement property.
The Role of a Qualified Intermediary (QI)
Furthermore, the funds from the sale of the relinquished property must be held in a Qualified Intermediary (QI) account until the replacement property is acquired. The QI acts as a third-party between the seller and the buyer.
Common Misunderstandings About 1031 Exchanges
People often get confused that they can sell an investment property and buy a personal property or vice versa, but they must remember that it needs to be investment for investment. This means that investment income is not a requirement, although it would be good proof if an audit occurred.
If friends and family are living in the property rent-free, and the individual wants to sell the property and invest in another one, it must be established that a fair market value is being paid. If the individual is selling a personal residence and has lived there for two out of the last five years, they can take up to $250,000 (if single) or $500,000 (if married) as an exemption.
However, if the total amount made from the sale exceeds the exemption amount, taxes have to be paid on the difference. If the individual has rentable space in their residence (Ohana), that portion of the property can be allocated for investment on the tax return, allowing for a 1031 exchange and a personal residence exemption on the other.
Depreciation Recapture and Partial Exchanges
Remember, it’s an investment for investment only. You can do a 1031 exchange with any combination of real property, such as commercial building, industrial building, single-family home, condo, or vacant land. However, if you exchange a depreciable property for a non-depreciable property, you will be subject to depreciation recapture — taxed at 25% — when you sell the replacement property.
If you do a 1031 exchange and replace the property with a primary residence, you will no longer be able to do a 1031 exchange when you come to sell the property. In order to qualify for the full personal residence exemption, you must own the property as an investment for two years and use it as your primary residence for two of the five years before you sell.
Prior to 2009, people believed they could do a like-kind exchange to sell their investment property, buy a replacement, rent it out for a year, move in for two years, then sell it and take their personal exemption. However, this stopped in January 2009.
Leasehold Property in Hawaii
In the case of a leasehold property in Hawaii, the property must have 30 years or more remaining on the lease in order to qualify. For vacant land, depreciation recapture and leasehold are two factors to consider. Furthermore, you must reinvest both the bases and the gain of the property you are selling in order to achieve a 100% deferral.
This means that the purchase price of the replacement property must be equal to or greater than the sales price of the relinquished property. If the replacement property is purchased for less than the relinquished property, then the difference will be exposed to taxes, resulting in a partial exchange.
Example:
When you do an exchange by selling something for $500,000 you need to buy something equal to or greater than $500,000 to achieve hundred percent deferral. You can also subtract commissions and escrow fees.
In this example, you’re selling a property for $500,000 and you’re paying your real estate agent 6% and the escrow fees are 1%. This will allow you to safely subtract 7% from $500,000. So, $465,000 would be the number to accomplish a 100% deferral. If you choose to buy a property for $400,000, then the difference of $65,000 will be exposed to taxes and that becomes a partial exchange. Buying lower is fine, however, you don’t want to buy too far down that it becomes a wash and makes no sense to do an exchange. When doing a like-kind exchange, you need to ensure the replacement property meets certain requirements.
Remember Deadlines
Finally, when doing a like-kind exchange, it’s important to talk to your CPA and also consider the 45-day and 180-day deadlines. The 45-day deadline is included in the 180-day deadline, and you must be mindful of holidays.
How to Identify Replacement Properties
To identify properties for an exchange, you can use either the Three Property Rule or the 200% Rule.
1. Three Property Rule
The Three Property Rule allows you to list the complete address and the unit number, city and state of up to three properties.
2. 200% Rule
With the 200% Rule, if you want to identify more than three properties, the fair market value of the entire list combined must not exceed double the sale price of the relinquished property.
Example:
If you sell property for $4 million, the list of four or more properties must not exceed $8 million. You have 45 days to make changes to the list, and the money from the sale of the relinquished property is the down payment for the new properties. The remaining balance for the new properties can be paid for with cash or a mortgage.
Tips for a Successful 1031 Exchange in Hawaii
If you are selling one property and buying three, you can let the exchange company know how the funds will be used. For instance, you may decide to pay for property number one in cash, put $300,000 on property number two and $200,000 on property number three. To complete the exchange, you will need to use all of the exchange proceeds as well as come up with cash or mortgage for the remaining balance, and close the properties within 180 days.
A regular exchange is the most cost-effective option; however, the 45-day period can be stressful as people often search for the perfect property. Remember, if you are not completely satisfied you can sell the property within the first year and do another exchange. Regular exchange fees start at $950 when you sell and $575 when you buy the replacement property, and the savings compared to paying taxes are immeasurable.
Thinking About a 1031 Exchange in Hawaii?
To successfully execute a 1031 exchange in Hawaii, ensure you engage a Qualified Intermediary, adhere to the IRS timelines, and understand the state's specific tax regulations. This strategy can be a powerful tool for deferring taxes and growing your investment portfolio.
If you’d like to discuss how a 1031 exchange could fit into your real estate strategy, or explore available investment properties across Hawaii, contact me anytime.
